Devin, thanks for your comment! Devin states that many academics feel that technical trading does not work nor does fundamental analysis for that matter. Another way of stating their point is to say that markets are efficient.
Market efficiency is a HUGE subject in the research world. There are camps that posit that markets are strongly efficient. That is, all information is reflected in the price near instantaneously. You can not produce consistent Alpha (a return beyond what the market itself gives you), and you cannot earn the full Beta (the market return) of an index because of transaction costs. This is the model Devin's comment implies.
The two other primary models of market efficiency are the semi-strong and the weak efficient market models. The semi-strong model says that all publicly available information is incorporated into prices (insider trading would give you an advantage.) The US Securities and Exchange Commission trading regulations believe this form of market efficiency. The weak form says that all past information is incorporated into prices and therefore technical trading should not work.
You can test for the weak form by measuring the serial correlation of prices through time. Repeated testing shows that there is near zero correlation. That is why academics state as Devin correctly noted, that technical trading should not work.
Technical traders would respond that academics are measuring the whole sequence of prices, not just the sections of interest to technical traders. People like Bob H, who has shared his technical trading system with readers, have exploited technical trading for years to produce alpha.
In the end, technical trading may work because there are enough people who believe in it to create their own market movements when certain patterns occur.
With regards to fundamental analysis, I hope it works, because that is what I do professionally. At the end of the day, I produce consistent alpha or get fired. So do I believe in efficient market models? Not completely. I believe there are market anomalies that we can profitably exploit over time. Any comment or rebuttal?
As you know, I am NOT a big fan of efficient markets. Efficient markets have all the price discrepancies sucked out of them. It is difficult to establish a decent spread between the bid side and the offered side of a market if it is priced efficiently. And from a trader's point of view, booking the difference in price within that spread alone (or in a portfolio manager's view, overcoming that spread) can account for the ENTIRE opportunity to book ANY profit on an arbitrage trade. Perhaps it is becoming somewhat easier for the dispassionate reader to understand why a trader and a portfolio manager, while both sharing essentially the same goal of making money, approach the process of achieving that goal from very different perspectives.
Posted by: Bob Hansell | March 7, 2006 3:05 PM | Permalink to Comment